The number of ways to invest your money is always growing and always adapting. Any good money manager will tell you that diversification is a key to long-term financial success. By investing in different asset classes, such as equities (stocks), fixed income (bonds), real estate, commodities, and so forth, an investor can maintain that all-important diversification.
But increasingly, we are seeing investments that combine traits of several asset classes. These new age investments are outliers, living in the investment wilderness where unfavorable traits like illiquidity, unproven markets and extreme volatility often live. Here are five new age investments that may warrant more investigation in your portfolio.
Investment #1 - Tontines
Want a little 17th century in your investing diet? Then look no further than tontines, an odd type of annuity created when a group of investors pool their money together. In the first tontines, each investor's share provided a small dividend for them. The dividend would increase when - wait for it - the first member of the investing pool died.
The deceased's share was divided up between the rest of the tontine holders. The process repeated with each remaining investor getting a larger share until just one remained. These morose investments were used successfully by European governments to fund wars hundreds of years ago, and were modified successfully in the 1800s to create life insurance pools.
In some circles today there are discussions of using the tontine model to create health insurance pools for the young and uninsured. The tontine model would give payouts to those who didn't need health services over the life of the contract, thereby providing an incentive to purchase the insurance in the first place.
Investment #2 - Structured Products
Structured products include a diverse number of products but in essence, the aim of structured products is to blend the features and the risk/reward benefits of multiple asset classes.
A typical structured product consists of a zero-coupon bond blended with a derivative like a long-term equity index option. The goal is to give the investor the benefit of downside protection of capital while exposing the investor to some of the potential upside of a stock market index like the S&P 500.
If you invested $10,000 in a structured note tied to the S&P 500, you could guarantee the principal payment (your $10,000 back at the set maturity date) while earning a portion of the gains the S&P makes over the life of the contract. If the S&P 500 was up 50% over the life of the deal, you might be entitled to half the gains. But if the S&P 500 was down 20% at the maturity date, you would keep your initial investment while having at least taken a shot at the stock market.
Structured products can be found at most major financial institutions, and come in all flavors depending on how much risk and how much protection you want. There are also potential tax benefits to structured products, but you're best advised to consider them only after consulting a trusted tax and investment advisor. (For a good primer on this diverse investment group, check out Understanding Structured Products.)
Investment #3 - Peer-to-Peer Lending
For a small 1% fee (much lower less than regular banks charge), peer-to-peer lending website Prosper.com posts borrowers that have had their identities and credit scores verified. You then get to play lender and choose to fund one or more loans yourself; most loans are between $2,500 and $5,000, and are paid back over a three-year term.
Prosper funded nearly $9 million in loans in the second half of 2009 alone, and the site keeps thorough metrics on the annualized return of each set of credit scores. The returns to date have been better than what you can find on bank CDs or Treasury Bonds.
Investment #4 - Master Limited Partnerships
MLPs aren't a new investment vehicle, but over the years they've remained under the radar. One reason is that there's not a lot of sales incentive for traditional brokers, and another is that the biggest benefit of MLPs comes on the tax side, eliminating much of the institutional (big buyer) end market.
Master limited partnerships work like limited partnership (LP) interests, except that most large MLPs are traded on stock exchanges, adding liquidity. Most MLPS are related to commodities and energy, and most pay very hefty dividends as they distribute nearly all income straight through to investors. By doing this, MLPs avoid having to pay income tax on dividends.
MLPs should only be held in taxable accounts, and can provide much higher yields than bond investments while having a similarly low risk profile. (To learn more about the tax advantages of MLPs, check out Discover Master Limited Partnerships).
Investment #5 - Hedge Funds for the Little Guy
Want to feel like a high roller at a limited price? The ever-growing ETF market is now aiming at you, offering hedge fund-like investments that trade just like stocks. Hedge funds aim to use quantitative techniques to find discrepancies between typical patterns in asset classes, sectors and individual securities.
One of the more popular ETFs is the iShares Diversified Alternatives Trust (NYSE:ALT), which seeks to profit from price discrepancies by purchasing derivatives like futures contracts and interest rate securities. The ALT may also short sell certain securities while overweighting others, a feature you won't find in your garden variety ETF or mutual fund.
The expense ratio for the ALT is notably higher than industry averages (0.95%) because it is actively managed, but if the fund succeeds in its goals it will provide solid returns that are not correlated to stock and bond market returns, providing some of that elusive diversification.
The Bottom Line
For most of us, traditional and tested investments remain the best way to plan for our long-term goals. But if you're feeling burned by the past two years, these new age investments could help you get back into the water. Because even though it's sometimes too cold for comfort, history tells that swimming there is much better than hiding your money under the mattress.